From Black Wednesday to Brexit: Macroeconomic shocks and correlations of equity returns in France, Germany, Italy, Spain, and the United Kingdom

Sylvia Gottschalk

International Journal of Finance & Economics, 2023, vol. 28, issue 3, 2843-2873

Abstract: This paper investigates whether macroeconomic shocks, such as the UK's referendum decision to leave the European Union (“Brexit”), the 2008 Financial Crisis, the 1992 ERM Crisis (“Black Wednesday”), and the 1987 stock market crash (“Black Monday”), had a positive impact on portfolio risk diversification. We estimate weekly dynamic conditional correlations and then optimal sectoral portfolio allocations between 1973 and 2019. Our results show that correlations of equity returns increased as a consequence of economic integration among European countries from the mid‐1980s until the late 2000s, and decreased in the United Kingdom after Black Wednesday and the Brexit referendum. We tested the existence of a correlation change‐point on June 27, 2016 by applying Wied et al. (2012)'s [Econometric Theory, 28(3), 570–589] correlation structural break test, which we modified to account for dynamic conditional correlations. Application of this test confirms that the referendum date was a break‐point in nearly all UK manufacturing industries. The failure of Lehman Brothers and the 1987 stock market crash were also identified as structural breaks in equity correlations. Moreover, our findings suggest that the Brexit vote may constitute a long‐term trend reversal of the convergence of equity return correlations in European markets, akin to Black Wednesday, rather than a shock like the 1987 and 2008 financial crises, which merely intensified a historical upward trend in correlations of European equity returns.

Date: 2023
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